Today, we will explore an event from 1992, that provides great insight for policy makers in Nigeria. Let's get ready to dive in.

Black Wednesday refers to September 22 1992, when a collapse in the pound sterling forced the UK to withdraw from the European Exchange Rate Mechanism(ERM) because it could not prevent the pound from falling below the lower limit specified by the ERM.

What is the Exchange Rate Mechanism?

The ERM was introduced in 1979 to reduce volatility in exchange rates and stabilize monetary policy across the euro bloc. Countries seeking to replace their currency with the euro were required to keep the value of their currency within a specific range for several years.

To maintain their values relative to each other, countries with the most valuable currencies had to sell their own currencies and buy the weakest ones.

ERM allowed fluctuations within a range, but if a currency reached its upper or lower limit, its central bank had to intervene to keep its currencies within the agreed range.

Black Wednesday Explained

The UK had been in the ERM for the two years leading up to Black Wednesday. Prior to this, the then British Prime Minister, Margaret Thatcher, did not want the UK's monetary policy subordinated to Brussels, the headquarters of the European Union. By 1990, she relented and allowed the UK to join the ERM at the rate of £1.00 to DM2.95 plus or minus 6% (DM is the former German currency, the Deutschmark). This rate was viewed by many to be too high.

At the time, the UK was going through a recession coupled with high inflation, high interest rates, a government budget deficit, a collapsing housing market and low competitiveness. Sounds familiar right?

The markets became doubtful about the Bank of England's ability to defend the pound. To make matters worse, the German Chancellor, Helmut Kohl, offered a generous 1:1 conversion rate for East Germans converting their currency to Deutschmark following the German reunification in 1990. This spurred inflation in Germany, and the Bundesbank (the German Central Bank) responded by raising interest rates, resulting in a stronger Deutschmark.

On the morning of September 16 1992, the Bank of England was forced to respond by raising interest rates from 10% to 12%. Currency traders were unconvinced that raising rates would work and continued to bet that the 6% band would not hold. And even when the central bank raised interest rates further to 15% later in the day, it failed to revive the pound. By 7 pm in the evening, the finance minister announced that the UK would leave the ERM. The markets had won!

The pound sank like a lead balloon, falling from above $2 to $1.50 within weeks, thus losing more than 25% of its value. The UK had spent £3.3bn defending the currency on the day.

Let's bring it home:

There is so much the CBN can learn from Black Wednesday. But before that, let's look at some recent reforms from the apex bank.

1. Selling of dollars to BDCs to stabilize the naira;

2. Raising the Monetary Policy Rate (MPR) to 26.25% from 18.75% and increasing the Cash Reserve Ratio (CRR) to 45% from 32.5%;

3. Clearing a significant backlog of foreign exchange obligations, which included a payout of $1.5 billion to restore credibility and liquidity in the FX market;

4. Limited payment of business and personal travel allowance to electronic channels;

5. Restricting the use of dollars as collateral for loans issued in naira, amongst others.

Research reports by the CBN itself have noted that the interventions were largely unsuccessful.

Lessons to be Learnt

Black Wednesday laid down the ideological and institutional foundations for free markets. The idea that markets could be tamed by politicians was killed off in this singular event, which ultimately led to the independence of the Bank of England.

There are lessons here for the CBN. The UK's economic problems ultimately led to the events of Black Wednesday. Nigeria faces similar problems - low productivity, high inflation, high interest rates, high indebtedness, low foreign reserves, and a groaning budget deficit.

There are steps we can take to avoid a similar situation in Nigeria.

1. Maintaining Flexible Exchange Rate Policies

Black Wednesday highlighted the risks of rigidly pegged exchange rates. The CBN should consider maintaining a more flexible exchange rate regime that can adjust to market conditions rather than defending a fixed rate at all costs. This flexibility will help avoid excessive depletion of foreign reserves and the need for abrupt policy shifts.

2. Coordinate Monetary and Fiscal Policies

There was a perceived lack of coordination between the UK's monetary and fiscal policies. The CBN should work closely with the Nigerian government to ensure that monetary and fiscal policies align. A strong economy can better support a stable currency.

3. Monitor and Manage Speculative Attacks

Speculative attacks on the pound contributed to Black Wednesday. The CBN should implement mechanisms to monitor and manage speculative activities in the currency market.

4. Diversify Foreign Exchange Reserves

The depletion of the UK's foreign reserves was a critical factor on Black Wednesday. The CBN should diversify its foreign exchange reserves to ensure that it has adequate liquidity to defend the naira when necessary. Diversification can provide a buffer against external shocks.

The government's fiscal policies must play a part in boosting productivity to reduce the country's burgeoning reliance on imports.

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